The Fama and French three-factor model in developing markets: evidence from the Chinese markets

Man Li,Michael Dempsey

doi:10.21511/imfi.15(1).2018.06

Abstract

The authors study the Fama and French three-factor (FF-3F) model in relation to a developing market. To this end, they consider Chinese stock markets over the period 1995–2008, which is to say, over a period when these markets are recognized as “developing” markets influenced by speculative activity. The authors find that the model appears to be working as a form of “principal component analysis for the determinants of stock price formation with book-to-market (B/M) as the “variable of choice” on account of that it captures the earnings-to-price (E/P), cash-flow-to-price (C/P) and sales-to-price (S/P) variables while remaining largely uncorrelated with firm size (whereas E/P, C/P and S/P are themselves positively correlated with firm size). The variables, however, are unrelated to risk as represented by market exposure, volatility, or leverage.

Highlights

The fundamental nature of factor models such as the Fama and French three-factor (FF-3F) model remains unclear
We provide evidence that the model succeeds as a form of “principal component analysis” whose factors are efficient in capturing a range of variables that are predictive of share price movements
In addition to standard tests, we examine the relationship between total volatility and average The average -weighted monthly returns of stock returns for both up-market and down-mar- 5x5 portfolios formed on size and B/M quintiles are ket conditions

Summary

Introduction

The fundamental nature of factor models such as the Fama and French three-factor (FF-3F) model remains unclear. The FF-3F model introduced two variables in addition to beta, which, they claimed, administered most of the “heavy work” in explaining historical stock price movements. These variables are the market equity (ME) value or size of the underlying firm, and the ratio of the book value of the firm’s common equity to its market equity value (B/M), which together “provide a simple and powerful characterization of the cross-section of average stock returns for the period 1963–1990” The authors concluded that “if stocks are priced rationally, the results suggest that stock risks are multidimensional” The authors concluded that “if stocks are priced rationally, the results suggest that stock risks are multidimensional” (Fama & French, 1992, p. 428)

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Results

Conclusion